Under Article 21 of the AIFMD, any AIFM running an EU-based AIF is required to appoint a single full scope depositary to carry out four core duties: cash monitoring, safekeeping and verification of assets and general oversight of the AIF. For EU managers with experience of running UCITS funds alongside their offshore Cayman fund(s), this arrangement is a familiar one, but for AIFMs marketing non-EU AIFs into Europe, the concept of appointing a depositary is unfamiliar.
This is made slightly easier in the sense that the AIFM of a non-EU AIF can, under article 36 of the Directive, avail of a "depositary lite" regime, where one or more entities can be contracted to carry out the three functions of the depositary. The benefit here is that it allows the AIFM to enter into service level agreements with their existing prime broker and administrator to undertake the asset safekeeping and/or verification, in addition to the cash monitoring roles required of the depositary, and then decide on who to provide the third, oversight function.
The obligations of a depositary lite are therefore broadly similar to a full depositary arrangement. However, one important point of difference is that there is no strict liability for the loss of any assets in the AIF. Instead, the liability standard is negligence for the depositary lite.
For hedge funds and private equity funds that have never needed a custodian, there are understandably a lot of questions they need to consider, the most obvious being cost.
As the depositary is only required to do the four core functions listed above, and nothing else, there is very little to differentiate among depositaries, as compared to when a fund manager appoints a fund administrator; in this situation, they will look at the skillset of the administrator, its experience and expertise across different fund strategies to ensure that they are a good fit.
"That is still important when selecting the depositary because it makes the relationship easier to manage on both sides, but pricing is a major consideration undoubtedly," says Gerry Warwick, Director of Heritage Depositary.
Cost versus risk profile
The cost of the depositary ultimately comes down to the risk profile of the AIF.
For an EU-based AIF, the full scope depositary will be on the hook for any liabilities suffered by the AIF as a result of asset misappropriation. This means that the depositary has to conduct a robust risk assessment of the AIF if the AIFM chooses to continue using an existing prime broker and administrator. Under this arrangement – referred to as an open architecture arrangement – the cost impact to the manager will be higher because the depositary will be required to enter into a discharge of liability arrangement with the prime broker and/or administrator.
Alternatively, by using an integrated model, a lot of the risk can be internalised and the cost impact to the manager is reduced. In this arrangement, a single counterparty acts as the administrator and depositary to carry out the cash monitoring, safekeeping and oversight functions.
As Mike Hughes, Global Head of Fund Services at Deutsche Bank explains, there are a number of benefits to this: "These include cost savings for the manager due to efficiencies in terms of system connectivity & data sharing, reduced burden on the manager to carry out due diligence and KYC on multiple entities, and generally having one point of contact from a relationship perspective."
Warwick stresses that under this arrangement, the administrator and depositary, as part of the same group, must operate as independent companies to avoid potential conflicts of interest. He agrees with Hughes on the efficiency point, noting that it makes for a "relatively smooth interaction between the two `in house' companies. It can be highly frustrating when waiting for information from an external 3rd Party, especially as our services have been tailored to ensure compliance with depositary functions under AIFMD and in a way that minimises disruption to the AIFM.
"Having easier access to all the required information and with the ability to put in place an effective integrated operating model allows for reduced risk and a more efficient service to the AIFM," says Warwick.
For over 20 years, CACEIS has been Depositary bank to some of the most well respected asset managers in Europe. Its depositary service is tightly integrated into its technology and as Clara Dunne, CEO, Caceis Bank Luxembourg (London) comments: "Where we also act as Fund Administrator to our clients, there are advantages for reporting and access to information. However, we understand that it is not always easy or expeditious to change service providers. Consequently, we do offer Depositary as a stand-alone service and are confident that over time we will prove to be the preferred partner to our clients in other areas; for example, fund administration services, where we are number one in Europe with EUR1.4trn in AuA."
PERE funds contribute to depositary growth
Indeed, for large established fund managers who decide to launch an AIF in Europe and need a full scope depositary, although the integrated model might make operational sense, it isn't necessarily feasible to move lock, stock and barrel into a single counterparty relationship – one could even argue that the concentration risk that would create would be counterintuitive to the AIFMD's aim of better protecting investors.
Nevertheless, there are clear signs that more PERE fund managers and hedge fund groups are exploring the benefits of launching regulated funds – AIFs and UCITS (for liquid hedge fund strategies) – and getting more comfortable with the role that the depositary plays.
"We are now a full depositary bank in nine European countries, including most recently in the United Kingdom. We have seen our assets under depositary increase phenomenally to over EUR820bn. It is self evident that AIFMD is responsible for a sharp increase in demand for depositaries and the growth of Private Equity and Real Estate funds has also contributed to this requirement," adds Dunne.
With respect to the oversight function, the last thing any fund manager wants is the depositary interfering unnecessarily in the way they run their fund. Deutsche Bank makes a point of focusing on taking time at the outset of a client relationship to understand the client, the fund structure, policies and investment mandate.
"We then tailor our standard oversight model to the bespoke requirements of the fund and client. We strike the right level of interaction with the manager and raise only true issues that are identified as part of oversight reviews. This cuts out `noise' and allows us, as well as the manager, to focus on key matters which fall outside of the agreed parameters," confirms Hughes.
Key considerations when appointing the depositary
Finding the right fit is vital for the AIFM when looking for a depositary. According to Warwick, AIFMs should consider the following criteria:
• Knowledgeable, experienced professionals with a thorough understanding of the alternative fund industry and who possess deep knowledge of the asset classes they service.
• Provision of flexible solutions and agile responses to meet the varying demands of each unique structure.
• Effective Systems and Controls with flexible reporting functions.
• Services tailored to ensure compliance with Depositary functions under AIFMD that are unobtrusive and minimise disruption to existing roles and relationships.
• Operational autonomy to enable it to provide depositary services to existing AIFM's who utilise in-house administration and also fund managers with an established third party administrator relationship seeking a segregated depositary function.
• A flexible operating model that delivers a service that is compliant with the Directive while ensuring that the needs and expectations of the client are met.
Hughes adds that the ability to provide full Depositary services versus merely Depo Lite services, accountability of management and staff, and a global footprint with a `bricks and mortar' presence in all key global markets "to sense check issues as they arrive" are also key considerations when selecting a depositary.
Having a depositary with a sound balance sheet and good technology is an equally important selection criterion for AIFMs and their investors. This is an important point because administration groups that have a depositary lite license – which ultimately restricts them to providing safe keeping of financial assets if they are not also part of banking groups – may not necessarily have the fortress balance sheets of global custodians.
"As there is doubt whether that can continue indefinitely, a consideration for any manager is the potential need to move service providers in the near future. We maintain that a depositary with great people, high-quality controls, and financial strength is increasingly important to a manager's investors," opines Dunne.
"A further consideration is the level of cooperation and shared technology platforms across different entities of the depositary, which is helpful to a manager who is distributing funds across geographies. It is an advantage for the manager to know that best practices and information on local and international regulatory developments are shared across all parties as they are at Caceis."
The role of technology
Technology advancements in recent years have helped administrators and depositaries cope with the added responsibilities they face under AIFMD. For administrators in particular, the ability to provide comprehensive regulatory reporting solutions to AIFMs has become a key criterion. Paul Kneen is Chief Operating Officer at Pacific Fund Systems, a technology specialist that provides investment fund accounting and administration through its integrated share registry/fund accounting platform, PFS-PAXUS. He notes that as AIFMs rely more on their fund administrator to ease the regulatory burden, the more automated the administrator can handle the reporting requirements the better. "It can certainly help give administrators an extra edge," says Kneen.
"We don't charge separately for the production of Annex IV and other regulatory reports. It is inclusive and made freely available to our administration clients. Should our clients wish to charge their end clients for the production of regulatory reports, it gives them an ability to increase their revenue stream. If we weren't providing this support, administrators would have to slice and dice a lot of this data using manual processes, spreadsheets etc., all of which would be time- and cost-intensive."
The ability to perform asset safekeeping, verification, cash monitoring, and general oversight of the AIF's activities necessarily involves a significant volume of data. As mentioned above, where these functions are performed within the same group, with the administrator and the depositary separated by Chinese walls, the transfer of data is more seamless than it would be when relying on data from multiple third parties. All of the data can reside in a central repository using systems such as PFS-PAXUS, giving the administrator significant granularity on the AIF, which it can then use to good effect for Annex IV reporting, FATCA reporting, Form-PF reporting and so on.
ConceptONE's regulatory enterprise risk management solution – RegERMTM – meets the regulatory reporting challenge by providing a truly holistic view, which is making the lives of administrators and depositaries so much easier, from a data management perspective.
"Some AIFMs in the past wanted us to work directly with them but the realisation now is that if we are doing this already with the fund administrators, it's just a more efficient system in general. The AIFM's business is a bit different to the administrator, which at its most basic boils down to data management and running fund data through complicated calculation engine to create responses for the regulatory report, and then fill in the gaps by going to the AIFM or to their outsourced risk provider," says Ethan Wishnick, Associate General Counsel & Vice President, ConceptONE.
The technology capabilities of the depositary must therefore be a final key consideration for any AIFM as they settle in to life under AIFMD.
